Market Structure, Scale Efficiency and Risk as Determinants of German Banking Profitability 1 2 Peiyi Yu and Werner Neus 1 Corresponding Author; Post-doctoral researcher, Faculty of Economics and Business, University of Tuebin- gen, Germany. E-mail: [email protected]. 2 Faculty of Economics and Business, Department of Banking, University of Tuebingen, Germany. 2 Market Structure, Scale Efficiency and Risk as Determinants of German Banking Profitability Abstract The Scale-Efficiency version of the Efficient-Structure Hypothesis and the Structural- Conduct-Performance Hypothesis find empirical support in German banking data from 1998 to 2002. Due to the acceptance of the two hypotheses and the existence of overall economies of scale, we conclude that German banks may improve their profitability by increasing their asset size and/or by consolidation. The increased banking profitability will not only come from monopolistic power (higher concentration rate) but also from the scale efficiency benefit. We also find that portfolio risk is a key factor in determining the profit-structure relationship. Keywords: Profit-structure relationship, Market Structure, Scale efficiency, Portfolio Risk JEL Classification: C33, G21, G14, L11 3 1. Introduction In a recent paper published by the IMF, Decressin et al. (2003) propose that recent weak bank profitability in Germany appears to be related with structural factors rather than the macro- economic cycle. Some anecdotal evidence and financial ratio analyses are also presented to support this claim. The motivation of this paper is to study the issue of bank profitability in a coherent and rigorous econometric framework with a large panel data set of the German bank- ing industry. Another main motivation is to go beyond the factors explored in the IMF paper in explaining why the profitability of the German banking system has been relatively low and trended downwards over recent years. For example, over 20 percent of Germany’s commer- cial banks in the Fitch IBCA database did not earn a rate of return for their owners that ex- 3 ceeded the rate of a risk-free treasury bill . This immediately leads to the question of how the structure and the organisation of the German banking system can be changed to safeguard banks’ profitability and the sector’s stability. First, we would like to give a brief overview of the German banking system. As shown in Ta- ble 1 below, the German banking system is composed of the three following pillars: commer- 4 cial banks, cooperatives, and public sector banks . [Please insert Table 1] These three pillars are all different with respect to ownership and objectives. For example, most of the public sector banks are effectively owned by state and local governments, which operate commercially but also have a public mandate and currently benefit from a govern- ment guarantee. The group of public sector banks comprises regional and national develop- ment banks, savings banks (Sparkassen), and their state banks (Landesbanken). Since these public sector banks are governed by public law, the mandate of the savings banks (Sparkassen) and state banks (Landesbanken) is to foster the economic development of their regions by fol- lowing viable business plans. Moreover, public sector banks enjoy the benefits of state guar- 5 antees which ensure that public sector banks are able to meet their obligations at any time. Because of these guarantees, public sector banks have the advantage of access to lower-cost funds relative to their lower-rated competitors. Although now the public sector guarantees are 3 Decressin et al. (2003) find that this is the case in any of the three years 1997, 1999, and 2001. Another indi- cator from the OECD suggests that Germany’s banking system pre-tax ROA reached about 1/4 percent in 2000-2001, having declined noticeably in the 1990s. 4 In addition, mortgage banks and building and loan societies (Realkreditinstitute and Bausparkassen) operate in all three sectors. Moreover, the continued operation of the state banks (Landesbanken) is guaranteed by the saving banks (Sparkassen) through the institutional protection scheme. 5 These guarantees are the “Anstaltslast” (maintenance obligation) and “Gewaehrtraegerhaftung” (liability ob- ligation). 4 6 being phased out , the removal of state guarantees does not mean that there will be no public support for public sector banks. Particularly the state banks (Landesbanken) are considered 7 too big to fail . Moreover, the phase-out of the guarantees will only have a limited impact on the savings banks (Sparkassen), because only few savings banks (Sparkassen) raise funds in capital markets. Savings banks (Sparkassen) predominantly rely on customer deposits and in- 8 terbank loans for the bulk of their funding needs . The second group in the German banking industry is the cooperatives (Volksbanken, Raiff- eisenbanken, Spar- and Darlehenskassen). This group of banks was founded as self-help or- ganizations for craftsmen, workers and farmers. Cooperative banks concentrate on their re- 9 spective local markets and do not compete with one another . Since cooperatives concentrate on a specific local clientele, this group of banks have an informational advantage in evaluat- ing the creditworthiness of their local borrowers, and the fact that depositors and borrowers are also mostly owners can reduce moral hazard. However, the disadvantage of this owner- ship structure and customer base has limited diversification in the cooperative banks’ loan portfolios. Finally, the major part of private sector banks are commercial banks. Commercial banks comprise the big four banks, which account for roughly two thirds of this sector’s business. 10 The private sector banks also include the Postbank , foreign banks, and numerous smaller banks. The biggest four commercial banks comprise Deutsche Bank, HypoVereinsbank, Dresdner Bank, and Commerzbank. Like the cooperative banks, they do not benefit from a public sector guarantee, and thus are at a disadvantage relative to the state banks (Landes- banken) in tapping capital markets. Also, the commercial banks run a generous voluntary de- posit protection scheme instead of an institution protection scheme. This generous voluntary deposit protection scheme is administered by the commercial bankers’ association to enable competition with public banks and cooperatives in deposit-taking. Moreover, commercial banks (including those that do not elect to be members of the voluntary deposit guarantee scheme) have to participate in the less generous statutory deposit protection scheme. Neglect- 6 On July 18, 2001, the European Commission and the German authorities came to an agreement to abolish the public sector guarantees for the savings banks (Sparkassen) and state banks (Landesbanken). The termination of government guarantees for public sector banks will start in mid-2005 7 Another reason is that the savings banks (Sparkassen) will still have to stand behind the state banks (Landes- banken), because of their institutional protection scheme. 8 The situation for the state banks (Landesbanken) is different, since nearly one third of their liabilities take the form of securities. Because of state guarantee, state banks (Landesbanken) can have better rating from the rating companies. 9 Although some used to focus on certain groups of the population, they are now offering services to everyone across the country. 10 The Postbank, which ranks among the country’s postal service, is a joint stock corporation under private law that.The majority of Postbank shares is still held by the Federal Republic of Germany. 5 ing the different ownership structure, co-operations and public banks exhibit a quite similar behavior. Generally speaking, from the Fitch IBCA database, we can observe that savings banks (Spar- kassen) and cooperatives currently have higher returns on equity than commercial banks. After reviewing the German banking system, we come back to the argument of how struc- tural factors affect German banking profitability. Many propose that the relatively low profit- ability of the German banking system could possibly reflect that profit maximization is not always the paramount objective of public sector banks and cooperatives. Furthermore, a high number of banks per capita leads to intense competition. For instance, Decressin et al. (2003) point out that competition in Germany appears to be more intense than in the United Kingdom and France. In the following part, we will attempt to find out how the market structure affects banks’ profitability by examining a model that can distinguish between three competing profit-structure hypotheses. Three profit-structure hypotheses have emerged in the banking literature to explain the profit- structure relationship. They are the Structural-Conduct-Performance Hypothesis, the Relative- Market-Power Hypothesis, and the Scale-Efficiency version of the Efficient-Structure Hy- pothesis. The Structural-Conduct-Performance Hypothesis states that banks set prices that are less favourable to consumers in more concentrated markets because of an imperfect com- petion. The Relative-Market-Power Hypothesis suggests that only banks with large market shares and well-differentiated products can exercise market power in pricing these products and earn supernormal profits (Shepherd, 1982). Finally, under the Scale-Efficiency version of the Efficient-Structure Hypothesis, all banks have equally good management and technology (the same X-efficiency), but some banks simply produce